In many ways pension funds can be forgiven for misjudging the direction of interest rates. Few would have believed they would still be bumping along the bottom, with any rumours to the contrary never seeming to materialise. Increases are in the air with the US starting to taper and the UK making noises about changing its monetary policy. It will not happen overnight but pension funds are advised to prepare for assets re-pricing.
One of the challenges is the goalposts keep changing. For example, the new Federal Reserve chairperson Janet Yellen recently announced that the central bank will no longer use unemployment as a target to determine rate increases, and will also factor in inflation. It is expected to end its bond-buying scheme in the autumn, as long as the economy improves, suggesting that an interest rate rise would not occur until next spring at the earliest.
The UK is expected to pursue a similar course of action although it is hard to pin down when rates will start their upward climb. “The banking collapse triggered by Lehman Brothers and the subsequent quantitative easing has led to low or negative real interest rates – i.e. interest rates being lower than inflation rates, so that the interest earned is less than the increase in prices,” says Pension Insurance Corporation co-head of business origination Jay Shah. “Many people feel that such low/negative real rates cannot persist, but if you look at the market’s long term expectations as reflected in interest rate and inflation swaps or gilts, you see it is not expecting a reversion any time soon.”
Some industry pundits though believe that a hike could come happen within a year, if inflationary pressures begin to build while others do not expect to see any increases until the end of 2015. The theory here is that the Bank of England would be loath to choke off any growth prospects. There are also different views over the actual size of the increase, according to a survey conducted late last year by Pioneer Investments. Canvassing over 50 UK and Irish pension funds, it showed the majority are expecting 10-year gilt yields to be in the 2 per cent to 3 per cent range at the end of the year. By contrast, the general consensus is between 3 per cent and 4 per cent with forward contracts pricing yields in within this range.
One reason perhaps for the divergence, according to Pioneer Investments head of institutional business development UK Jonathan May is that the study was conducted in the wake of the forward guidance issued by new Governor Mark Carney. He indicated overnight interest rates would be held at 0.5 per cent until unemployment levels fell below 7 per cent. It also set out several circumstances whereby these rates might rise before this trigger, but based on their outlook at the time. Fast forward to today and the unemployment rate has fallen below the government’s threshold level, while the claimant count has dropped at the fastest pace since 1997. This positive momentum in the UK’s recovery has led the bond market to question the central bank’s expected timing of interest rate rises, leading market yields to gradually rise in anticipation of the central bank’s actions.
May believes there should be more focus on the long end of the curve. “I think there is a misunderstanding in that when the Bank of England looks at rates, they are focusing on short term overnight interest rates but the prices and yields in the market are based on future assumptions and the Bank does not dictate those yields. Also, rising interest rates can be a double edged sword in that the current valuations of liabilities are reduced but any fluctuations in interest rates could have a dramatic effect on a fund’s valuation. This is why we believe there may be a need for more education around bond markets. Asset managers need to help schemes better position their portfolios effectively in order to protect their assets from rising yields and benefit from improved funding levels as their liabilities fall.”
Aon Hewitt senior partner John Belgrove also believes pension funds need to start paying more attention. “Structurally pension funds that are closed and frozen are maturing more rapidly and many need to focus on their end game. Plan assets versus liabilities are accounted for on corporate balance sheets via a mark to market convention which means they are more impacted by funding volatility. However, our analysis suggests that on average UK pension schemes are leaving themselves over-exposed to long-term rate changes when compared to many other risks. We found that the majority of closed or frozen defined benefit pension schemes are significantly under-hedging their long-term interest rate risk at between 30 per cent and 40 per cent and we believe the ratio should be at least 70 per cent. The difference is around £400 billion.”
There is of course no one-size-fits-all solution. Pension funds will select investments and strategies that best fit their own specific requirements and profiles. There are though a few basic steps that they can take, such as sizing all risks appropriately and understanding the impact that further interest rate, and inflation, hedging can have on their scheme, according to Belgrove. “There are different tools that pension funds can use to manage these risks, often in derivative form, but that may add more complexity to trustees. The larger schemes have the resources and can use them in a segregated account but while there used to be limited options for smaller schemes this has changed significantly now and there are many top quality pooled solutions to access. We are seeing schemes increasing their hedging ratios through synthetic solutions and freeing up capital to invest in better yielding fixed income assets such as high yield, emerging market debt and multi asset credit strategies.”
Redington’s co-head of asset and liability modelling Dan Mikulskis also believes pension funds need to “right size” all risks including equity, credit, inflation and interest rate risks. “The general questions they should ask is how much total risk can I afford to take and be exposed to? Although this will vary depending on the scheme, the common theme we have seen is that pension funds are always surprised at the risks they are running.
“We start by running an analysis on where the risks are coming from. We then work with clients to implement a liability driven investment strategy in order to help manage interest rate and inflation risks, which typically involves hedging tools such as long dated gilts and interest rate swaps. LDI in itself is not a new concept, and there has been a higher level of adoption over time. I would agree with the Aon paper in that the average level of interest rate hedging among UK pension funds is probably 30 to 40 per cent, and this probably still leaves interest rates as the largest risk for a lot of schemes. However behind the average figure there is a large spread in terms of what schemes have done with some having adopted a high level of interest rate hedging, but others having done none. What we have seen over the years since LDI has become mainstream is that it does take time though to change behaviour and the mind set of trustees, but the toolset is available for those that do.”
Shah adds: “Pension schemes could hedge them and still invest in return-seeking, bearing in mind “return seeking” can also lead to “loss making”, through various LDI strategies. But this ignores longevity risk and other demographic risks which are just as uncertain as asset returns. Trustees will decide how much risk they are prepared to take based on how much risk the scheme can bear which in turn depends on sponsors ability to fund an increasing rather than decreasing deficit if things go wrong. Ultimately, the only way of removing all the risks altogether is through a buy-in or buyout.”
Lynn Strongin Dodds is a freelance journalist